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Supreme Arbitrazh Court rules on use of promissory notes as security - International Law Office

Litigation - Russia

Supreme Arbitrazh Court rules on use of promissory notes as security

In Summer 2011 the Supreme Arbitrazh Court drew a line under a dispute about promissory notes that had dragged on since 2009.(1) Resolution 16623/10 corrected the approach of the lower courts, which had held that the only lawful basis for issuing a promissory note was, in essence, a loan relationship, and had stated that a promissory note may not be paid if it is issued to secure a third party's obligation.

Background

There had been no previous case law from Russia's highest courts in relation to the legal force of so-called 'accommodation promissory notes', which are issued not in exchange for goods or money, but as security. Therefore, the courts proceeded on the basis that the sole legal grounds on which a promissory note may be issued is a monetary obligation to the noteholder (ie, a loan). Central to this analysis was the concept that the loan implies a delay in a payment that the issuer of the note is required to make.

Lower courts' findings

The lower courts established that the claimant was the holder of five simple promissory notes issued by the defendant, an individual entrepreneur, to a third party. On their date of issue, the promissory notes in question were assigned by the third party to the plaintiff and were endorsed with the words 'currency in pledge'. When the payment date arrived, the notes were presented to the issuer, but the latter did not pay.

In rejecting the claim, the courts considered that the promissory notes in question had been issued without proper grounds, since the issuer (ie, the defendant) had no monetary obligation to the third party (ie, the first noteholder) and it was alleged that the claimant had been aware of this.

In examining the disputed legal relationship, the lower courts applied Articles 17 and 19 of the Regulations for Bills of Exchange and Promissory Notes.(2) The courts observed that the absence of a monetary assignment to the holder of the promissory note upon issue meant that the note had been issued without proper grounds. Therefore, the claimant's actions should be regarded as having been performed with the intention of causing detriment to the issuer of the promissory note.

Supreme Arbitrazh Court interpretation

The Supreme Arbitrazh Court ruled that this interpretation of Article 17 was incorrect. Clause 15 of the applicable resolution on promissory notes(3) clarifies that a party against which a claim is made under a promissory note is entitled to rely on the objections arising from its relationship with the lawful holder that brought the claim in question. Thus, a party with an obligation under the promissory note is exempt from payment if it can show that the creditor which is making the claim:

knew (or should have known) when it acquired the promissory note that the note had been issued on the basis of an invalid (or non-existent) obligation;

obtained the note through theft; or

knew or should have known of such circumstances before (or at the time of) acquiring the note.

The court agreed with the claimant's argument that in Russian legislation, there is no lawful basis for the issuance of a promissory note if:

the obligation that was the underlying basis for the issuance of the note is invalid or non-existent; or

the noteholder acted fraudulently.

On the facts, the court ruled that the defendant had more than once issued promissory notes to the third-party company, of which the defendant's wife was the general director and founder. These promissory notes were then endorsed with a notice of pledge and assigned to the claimant, which was supplying the third party with goods on delayed payment terms. The third party and the defendant had concluded an agreement whereby the latter expressed its intention to provide security under the contracts concluded by the company.

The court assessed the available information and concluded that the lawful basis for the issuance of the promissory notes in question was a security transaction whereunder the defendant assumed the obligation to be answerable to the claimant for the third party's performance of payment obligations in relation to goods received by the third party.

In addition, the court indicated that the law does not limit the basis for the issuance of a promissory note. In itself, the fact that no money or other property was granted to the first noteholder did not indicate that there were no grounds for issuing the note or that the noteholder had acted fraudulently. Thus, the lower courts had reached the wrong conclusion on the absence of an underlying obligation as a basis for the issuance; the expression of the will of the issuer indicated its intention to assume an unconditional payment obligation under such promissory notes by way of guaranteeing payment under sale and purchase contracts.

The case was referred for rehearing by the first instance court, to allow it to find that the amount secured by the promissory notes should be paid.

Comment

The Supreme Arbitrazh Court's decision is significant, both legally and economically. The lower courts were found to have taken an incorrect approach to the legal classification of promissory notes that are issued as security for an obligation to pay for goods supplied. Their interpretation not only violated the law, but impinged on the lawful rights and interests of a wide range of business entities. Issuing a promissory note may be a good way for small and medium-sized businesses to provide security for their obligations. It is necessary to pay - sometimes handsomely - for a bank guarantee to be issued and a surety depends on how the principal obligation is performed, whereas a promissory note is an unconditional obligation to pay, but costs nothing to issue. The only risk for a holder of a promissory note is the insolvency of the debtor. However, this risk also hangs over a guarantee and is more financial than legal in nature.

The court's position on the accommodation of promissory notes issued as security will be interesting for lawyers and businesspeople from countries that are signatories of the Convention Providing a Uniform Law For Bills of Exchange and Promissory Notes.(4) Russia's highest court has, in essence, given its interpretation of the uniform law, which is mirrored in Russia by the regulations for bills of exchange and promissory notes.(5)

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